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Speaking of the Economy
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Speaking of the Economy
Aug. 9, 2023

Uncertainty About the Effects of Monetary Policy

Audiences: Business Leaders, Economists, Policymakers, General Public

Paul Ho talks about how economists model the interactions between monetary policy and the economy and the challenges of determining the economic effects of policy with precision. Ho is an economist at the Federal Reserve Bank of Richmond.


Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. My guest today is Paul Ho, an economist in the Richmond Fed's Research department. Paul, welcome to the show.

Paul Ho: Thanks, Tim. It's good to be here.

Sablik: I'm excited to have you on today to talk about a recent Economic Brief you wrote which asks the question, "Why are economists still so uncertain about the effects of monetary policy?" It's a question many Fed watchers have been asking over the last few years. The Fed has been engaged in monetary policy tightening in an effort to bring inflation back down to its long-run target of 2 percent. But there's been a lot of discussion around how long this process will take and how high the Fed will need to raise rates to accomplish its goal.

Why is it so difficult to forecast how monetary policy changes will impact inflation?

Ho: Well, the first thing to remember is that the economy is incredibly complicated. It consists of lots of households, firms [and] financial institutions, all interacting with each other.

It's impossible to predict every single detail of these interactions. So, what economists try to do is to look back at what has happened historically to, say, inflation or unemployment and then try to extrapolate it to today. Unfortunately, this is hard because, firstly, we don't have that many historical episodes to look at. Each cycle takes several years to play out and a lot of the data we have only date back to the '60s. On top of that, each period has its own unique features, which makes it even harder to extrapolate.

This is an even bigger issue with the current episode we're going through. We're coming out of a historic pandemic, we've had unprecedented supply chain issues, we have a war in Ukraine, not to mention the government's fiscal response in the midst of all this. So, what is normally already a difficult problem is even harder in today's environment.

Sablik: Is there anything that economists do agree on when it comes to how monetary policy interacts with the economy? Or do they all have different models for thinking about this?

Ho: There is agreement on the broader strokes. We know that raising interest rates drives up borrowing costs. This causes households and businesses to want to borrow and invest less, and that ends up decreasing demand and lowering inflation. But on the finer details, there's much more uncertainty.

Take the question of what exactly is tight or loose monetary policy. This requires figuring out what's the right baseline so that you can say interest rates are high or low. The Richmond Fed publishes one such measure of this so-called "natural interest rate" developed by Thomas Lubik and Christian Matthes.

If you look on the website, you'll notice two things. First, the range of plausible values is between 0.4 to 4.4 percent. Even if you fully trust the model that's being used, that's a four-percentage-point range and that's big. Second, if you look at the point estimate, that looks quite different from some other models. For example, the New York Fed has a different model and they find an estimate that's about one percentage point lower than what the Richmond Fed publishes.

There are lots of other examples, ranging from how we think about the labor market to the precise role of different financial institutions. But the point is that while we have some agreement about the general mechanisms, there are also many, many issues that are not fully resolved. These really matter when we want to think about the issue of monetary policy quantitatively.

Sablik: Is there anything about the current policy cycle that the models have failed to predict? For instance, there's been some discussion around the fact that monetary policy tightening is often associated with higher unemployment and we haven't seen that yet.

Ho: I think there are a couple of things to unpack in your question.

First, what did models predict given the path of monetary policy that the Fed has taken? There certainly were models that predicted inflation falling faster or unemployment rising faster. But there were also models that did predict that inflation would take a while to fall and that unemployment wouldn't rise much. All of these models, of course, had uncertainty built into them. So, they might say there's some probability inflation would fall rapidly, but that still leaves the possibility of inflation remaining high. In other words, I think economic models did give a wide range of possible scenarios, and the current one certainly wasn't outside the realm of possibility.

There is another issue in this, which is has monetary policy had its desired effect? This requires us to ask what would have happened if the Fed hadn't raised interest rates. That means economists need to isolate the effect of monetary policy from all the other economic forces working in the background, so we've got to strip away the pandemic, supply chain issues, the war in Ukraine, and so on and so forth. Of course, this is a really hard task because there's no alternate universe where we can just run this experiment.

So, yes, unemployment hasn't risen so far. But how much tighter would the labor market be if interest rates hadn't risen? How much further would wages have risen? What would inflation be now? These questions are by no means straightforward and economists continue to work actively to answer them.

Sablik: We've been talking a lot about the uncertainty in the models. Can you give us a sense of the size of uncertainty in the models used to analyze monetary policy effects?

Ho: One way to look at this question is to look at the range of forecasts in the Summary of Economic Projections that the FOMC participants give every quarter. Each participant brings their own perspective to the data and to models, so the level of disagreement can give us a sense of how different the various model predictions might be.

In the most recent forecast from June 2023, we have projections for inflation that range from around 3 percent to 4 percent for 2023. For 2024, this range increases to around 2 to 3.5 percent. I think what's more striking is that the range of expected appropriate interest rates goes between 5 to 6.25 percent for 2023 and between 3.5 to almost 6 percent in 2024. These are, of course, wide ranges and should give you the sense that there's substantial disagreement about not only the effectiveness of monetary policy, but also how the underlying economic conditions are going to evolve quantitatively.

Sablik: What are economists such as yourself doing to try and generate more accurate predictions of monetary policy's effects?

Ho: First, as I've mentioned, the economy is super complicated, so it's useful to disentangle that complex web of interactions. Second, the economy is a moving target. New economic data is coming out all the time. Consumer sentiment is constantly evolving. Lots of unpredictable events can happen that could change where we think the economy is or might be going.

One big thing that economists do to deal with these challenges is to look at more disaggregated data. Take inflation, for example. You'll hear the Fed chair talk not just about aggregate inflation but also inflation in specific segments of the economy. Looking at these details can help us understand what's going on under the hood and make sense of the aggregate data. Maybe monetary policy has had an effect on some industries but not others, so we want to break down the aggregate data so that we have a better sense of where we stand and what impact monetary policy has had. That can hopefully help us better predict where we are headed.

Sablik: Is there anything in particular that you will be watching over the next few months to get a better understanding of the effects that monetary policy is having?

Ho: I've already mentioned looking at disaggregated data, particularly for inflation. We've also been raising rates for almost one and a half years now, so we'd like to eventually start seeing some effects, even in sectors like housing that we know tend to take a while to respond.

In the labor market, we've seen vacancies slowly come down since the Fed started raising rates. Conditions are still quite a bit higher than anything we've seen in the past 20 years. But I think the continued loosening of labor markets would point to a cooling economy, even if unemployment doesn't immediately increase. So those are just a couple of examples of useful data to look at.

But I do want to emphasize, again, that there's no magic bullet. There's no single indicator that's going to tell us for sure that inflation is going to return to target in this many months or unemployment is going to stay below 4 percent.

There's always going to be some degree of uncertainty. We need to acknowledge that and be humble about how much we know, especially when setting policy.

Sablik: Paul, thanks so much for joining me today to talk about your research.

Ho: Pleasure to be here. Thanks for having me.

Sablik: Listeners can find a link to the Economic Brief we discussed today on the show page, as well as other data and research on our website. And if you enjoyed this episode, please consider leaving us a rating and review on your favorite podcast app.

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